Speech The Evolving Financial Situation

Good morning, and thank you to Finsia for the invitation to speak here today.

We're fortunate to be meeting today in an environment where the worst of the
financial crisis seems to be behind us.

This time last year, things were very different. World financial markets were reacting
to the extraordinary events of the month before – the failure of Lehman
Brothers, and the string of other high-profile failures and near-failures that
occurred in the United States and Europe around the same time. Confidence was
collapsing, equity prices were falling sharply and wholesale credit markets
were in a state of serious dysfunction. These events, in turn, were driving
a severe downturn in global spending and output.

Today we can see with hindsight that the period of maximum disruption to the world
financial system extended over roughly the six months from September 2008 through
to March this year. It was during this period, too, that governments around
the world were responding with some of their most significant measures of emergency
support, including expanded depositor protection, guarantees for banks'
wholesale debt, and in some cases direct injections of capital into the banking
system. All of that was in addition to the substantial stimulus from monetary
and fiscal policies aimed at alleviating the general economic downturn. Taking
these things together, there's no doubt that the scale of both the crisis
itself, and the set of policy responses to it, have been the largest in more
than a generation.

That was the situation a year ago. The good news is that things are now improving,
and have been for some months. The world economy is returning to growth, confidence
has picked up and, over the last six months or so, financial market conditions
have improved significantly on a number of fronts.

Given these developments, my theme today is one of cautious optimism about the global
situation. We can't yet say that things are back to normal, and we still
can't rule out further setbacks. But the extreme downside risks that
dominated the scene a year ago now seem to have faded. And throughout this
period, the Australian banking system has proven to be a lot more robust than
some of its counterparts abroad.

I'll take the opportunity to elaborate on those themes by drawing on material
from our recent Financial Stability Review, which was released last month. Along the way, I'll also try to highlight some
areas of continuing risk that still need to be watched.

The Global Financial Environment

A good place to start is with global equity and credit markets.

Given the central position of the banking sector in the unfolding of the crisis,
it's not surprising that when equity prices were falling, bank shares
generally fell more sharply than the market as a whole. Taking July 2007 as
a starting point, bank shares in the United States, the euro area and the UK
all lost around 80 per cent of their value by the time the trough was reached,
with the steepest falls being concentrated in the six–month period after
the Lehman collapse. But since March this year there has been a significant
turnaround. Bank shares have generally been outperforming the wider market
on the way up, and in those same economies they have now recovered around a
third of their earlier lost ground.

Graph 1

It's interesting to note in passing here the comparative performance of the
major Australian banks. On a number of counts the Australian banks have been
much more resilient through the crisis period than their counterparts overseas,
and this was reflected, among other things, in a less severe fall in their
share prices. I'll say more about the Australian banks later.

Another indicator of the general improvement in confidence has been a narrowing of
financial risk premiums. After widening spectacularly late last year, bank
CDS premiums, for example, have generally now returned to pre-Lehman levels,
although they're still high by earlier standards. There has also been
a substantial narrowing of spreads on bank bonds over government securities,
and in short-term spreads between banks' wholesale borrowing costs and
expected official rates. All of those markets have been moving in the same
direction, towards greater normalisation.

Graph 2

So the extreme risk aversion of late last year has been easing for some months now,
and banks' access to wholesale funding markets has been improving. It's
important to keep this in perspective: these market indicators are still, in
some cases, a long way from pre-crisis levels, particularly for borrowing costs
at longer maturities. But the improvement over recent months is nonetheless
encouraging, and it has been broadly based across a range of major economies
and markets.

There are several factors we can point to that have underpinned this recent recovery
in sentiment. They include improved prospects for the global economy, the government
policy actions that I talked about earlier, and the actions of banks themselves
to begin the task of repairing their balance sheets. In the United States,
the stress tests that were done earlier this year prompted significant capital
raisings by some of the major banks; and by making the potential capital needs
clearer, the exercise seems to have contributed to the broader rebuilding of
confidence.

Another important contributor to confidence has been a recovery in bank profitability.
Losses of the major global banks generally peaked in the second half of 2008.
In the United States, federally insured banks collectively lost around US$12
billion last year, but in 2009 to date they have recovered to a position of
aggregate profit. Broadly similar profit recoveries have been seen at the aggregate
level in the UK and the euro area. Within those aggregates, of course, there
is significant variation at the level of individual banks.

Graph 3

While all of this is encouraging from a financial stability viewpoint, there are
still challenges ahead. One reason for the sharp spike in losses, and the subsequent
rebound in profitability, is the one-off nature of the securities (and other
asset) write-downs that were concentrated in the second half of last year.
Crisis-related securities losses by the largest international banks are estimated
to have peaked at over US$200 billion in the second half of 2008, and then
fallen to around US$60 billion in the first half of this year. This factor
on its own made a big contribution to the turnaround in total profits, but
it is essentially a short-term influence.

Graph 4

The factor that will take longer to play out will be the evolution of losses from
banks' on-balance-sheet lending. Over the past two years, loan loss provisions
by banks in the US and Europe have increased substantially, although they were
coming from a low level. Based on data for a group of the largest banks in
these economies, loan losses were up by 70 per cent in the first half of 2009
from their levels a year earlier. In the case of the major US banks, they were
running at around 4½ per cent of the aggregate loan book.

It's difficult to say at this stage how quickly these loan losses might start
to taper off. In the United States, loan performance up to this point has been
deteriorating across all the main categories of lending. Charge-off rates have
been particularly high for consumer debt, where loan quality has been affected
by a combination of poor lending practices and rising unemployment. It's
possible that losses in this area will rise further. But perhaps the more important
area to watch, both in the US and elsewhere, will be exposures to commercial
real estate. With commercial property prices having fallen significantly in
many countries, loans to this sector are generally expected to be amongst the
worst performing. And past experience suggests that the dynamics in this sector
may take a while yet to unfold.

Graph 5

Having raised that point of caution, however, it's important to recognize that
real progress has been made in strengthening banks' balance sheets since
the crisis broke out. The profit recovery has assisted with this, but banks
have also been taking active steps to strengthen their balance sheets by selling
non-core assets and raising new capital, as well as benefiting in a number
of cases from public capital injections. In total, the largest banks in the
US and Europe have raised nearly US$500 billion of new capital since the fourth
quarter of last year. While a lot of that came initially from public sources,
in a number of cases that has now been replaced by private investment.

Graph 6

Another encouraging development internationally has been improved access to non-guaranteed
wholesale funding. As I said earlier, risk spreads on a range of credit instruments
have been narrowing significantly from last year's peaks. At the short
end of the curve, spreads on 3-month wholesale funding relative to expected
official rates have more than fully reversed their post-Lehman spikes. They
are still higher than pre-crisis levels, but those should not be regarded as
permanent norms.

Graph 7

At the long end of the curve, the contraction in spreads has been less pronounced,
but is nonetheless helping to make unguaranteed issuance more attractive. In
conjunction with some other factors, this has contributed to a decreased reliance
on the use of guaranteed debt around the world. Over the past six months, the
bulk of issuance by US banks, for example, has been in the unguaranteed market.

Attention in many countries has now turned to how to exit from these emergency support
arrangements. The US government has confirmed that its wholesale guarantee
scheme will expire at the end of this month. The most common expiry dates in
other major economies are at the end of 2009, although some are later.

Graph 8

Before I turn to Australia, one final point to make about international financial
conditions is that the process of de-leveraging and balance-sheet repair also
has its counterpart in the private non-financial sectors. Both the household
and business sectors in the major economies have been reducing their levels
of debt, and businesses around the world have substantially increased their
raisings of equity. For the time being, this is an environment where the private
sector's demand for credit in the major economies could remain quite
weak.

The Australian Financial System

Let me turn now to the domestic scene.

Overall, the Australian banking system has remained resilient throughout the crisis
period.

One very clear point of contrast to the situation elsewhere in the world is that
the Australian banking sector has remained profitable. For the major banks,
the rate of return on equity has so far fallen only modestly. In the latest
half-year, it dipped to around 13½ per cent. This is lower than it had
been for a few years prior to that, but still a very strong performance in
the circumstances.

Graph 9

There has, however, been some diversity of performance across the different categories
of domestic banks. The smaller banks, including the regionals, have reported
a sharper decline in profitability, partly because their loan losses have increased
faster. They were also less successful than the major banks in maintaining
growth of their net interest earnings. Nonetheless they have, to date, remained
in profit overall.

There are a number of factors that have contributed to the overall resilience of
the Australian banks, in what has been a very difficult environment internationally.

An important general point is that the performance of the financial system is closely
interrelated with the performance of the economy itself. Australia came into
the most intense phase of the crisis period in better shape than most, and
with more scope than most to make timely macroeconomic policy responses. Partly
as a result of that, the overall slowdown in the economy has been much milder
than elsewhere. We have also benefited from our close linkage with the Asian
region, where financial sectors were less affected by the crisis and economic
conditions have bounced back reasonably quickly. In fact, what's commonly
referred to as a global financial crisis has been mainly a crisis of the United
States and Europe.

That said, there have also been important aspects of the Australian financial system
itself that contributed to domestic resilience. One is that the Australian
banks had only very limited exposure to the types of securities that led to
major losses abroad – US mortgage-backed securities, CDOs and the like.
The Australian banks were making good profits in their domestic operations
and, in a period when banks in some other jurisdictions were building up large
portfolios of high-risk securities, the Australian banks tended to focus their
activities on domestic lending.

Another factor is that the quality of banks' on-balance-sheet loans did not
deteriorate to anywhere near the same extent as occurred in the United States
and Europe. The difference here is particularly striking for the housing loan
portfolio. In Australia, despite a gradual increase over the past few years,
banks' non-performing housing loans are still only a bit over ½
of one per cent of the amounts outstanding. In the UK and Spain, that ratio
is between 2 and 3 per cent, and in the US it is approaching 6 per cent. These
differences tell us something about the deterioration in lending standards
that occurred elsewhere, but they also testify to the generally sound practices
that have continued to prevail in the Australian housing market over recent
years. And this in turn has made a very important contribution to the banks'
overall balance-sheet quality, given that housing loans comprise around 60
per cent of their aggregate loan book.

Graph 10

There has, however, been a more significant deterioration in loan quality in the
business portfolio. Impairments on commercial property loans have been increasing
over the past couple of years, and business loan losses more generally have
picked up as the economy slowed. This will remain an area to watch in the period
ahead. Nevertheless, banks' aggregate impairment rates are still low
in comparison to other countries, and they are only a fraction of the level
they reached here in the early 1990s. The banks are well capitalised, and they
have strengthened their balance sheets further over the past year with significant
additional raisings.

Graph 11

With asset quality generally remaining resilient, the main effect of the global crisis
on Australian banks has been through its effect on funding conditions. As was
happening elsewhere in the world, wholesale funding became both more expensive
relative to the policy rate, and more difficult to obtain. And at the height
of the crisis, some markets were effectively closed altogether. The introduction
of the guarantee scheme late last year played an important role in ensuring
continued access to wholesale funding for the Australian banking system, and
in that way enabled the system to continue lending through the most intense
phase of the crisis.

But for some months now, the strains in global markets that gave rise to these difficult
conditions have been gradually easing. Australian banks have benefited from
the general narrowing in risk spreads and the increased tolerance for risk
that I discussed earlier. Short-term wholesale spreads for Australian banks
have contracted quite markedly and, at longer terms, the availability and cost
of unguaranteed funding have improved. As a result, the proportion of banks'
long-term issuance that is unguaranteed has been increasing: it rose from next
to nothing at the end of last year to around 75 per cent in the latest month.

Graph 12

Another consequence of the recovery in risk appetite is that spreads in the Australian
mortgage-backed securities market have narrowed. Again, they are still high
by earlier standards, but they have narrowed sufficiently to support some renewed
issuance to private investors over the last couple of months. All of these
are encouraging signs, and certainly a significant improvement on conditions
earlier in the year.

Conclusion

As I said at the outset, my theme today has been one of cautious optimism.

The past year has been an extremely challenging time, but Australia's financial
system, like the economy itself, has come through it in better shape than most.

Globally, we can't yet say that conditions have returned to normal. Risk pricing
in a number of areas is still high, and there are still some areas of significant
risk on financial-sector balance sheets. But the extreme dislocation of a year
ago has passed. Market conditions have been on an improving trend for several
months, and the risks to the world financial system now seem much more evenly
balanced than they were.